Meaning
An international transfer pricing framework allocates the returns from intangible assets based on the economic activities performed, assets used, and risks assumed in their creation and preservation. In Chinese taxation practice, the State Administration of Taxation utilizes the dempe framework to analyze whether the transaction returns of a foreign invested entity match its actual contribution to intellectual property. This methodology limits the ability of foreign headquarters to extract high royalty payments from Chinese subsidiaries without proving that the parent company performs the corresponding management functions.
Value Allocation
Tax authorities distribute the economic benefits of intellectual property based on the physical location of the development, enhancement, maintenance, protection, and exploitation activities. Under Chinese administrative guidance, the dempe analysis requires detailed documentation of the personnel who make the active decisions regarding research projects. If the Chinese subsidiary performs the actual research but the legal ownership of the patent sits with an offshore entity, the offshore parent is denied the majority of the residual profits.
This treatment ensures that the entity carrying out the work retains the associated taxable income.
Regulatory Enforcement
Administrative audits conducted by Chinese tax officers focus intensely on the personnel records of local research centers to verify their functional contributions. Under Bulletin 6 of the State Administration of Taxation, enterprises must provide concurrent transfer pricing files that demonstrate the alignment of functional profiles with legal asset ownership. General service agreements that fail to show the execution of dempe functions in China are routinely rejected.
Consequently, local tax bureaus will disallow the deductibility of outbound royalty expenses that do not align with domestic research activities.
Operational Alignment
Foreign parent companies must establish operational substance in the jurisdiction where they claim intellectual property rights to secure royalty payments. Without such substance, the payment of royalties across borders will be classified as an unearned profit distribution.
